A redemption of stock owned by a shareholder of a corporation may be characterized as a "sale or exchange" under IRC Section 302 or as a "dividend" payment under IRC Section 301. The manner in which the redemption is characterized will determine the tax treatment afforded the redemption and, more specifically, may impact whether the shareholder must report the income realized on the transaction as capital gain or ordinary income as well as the amount of income that must be reported.
Generally, under IRC Section 302, a redemption of stock will be treated as a distribution in part or full payment in exchange for the stock and, therefore, generate capital gain (i.e., essentially treated as a sale of the stock), if it falls into any one of the following categories:
- the redemption is "not essentially equivalent to a dividend";
- the redemption is "substantially disproportionate";
- the redemption is for all the shareholder's stock;
- the redemption is a "partial liquidation" of the distributing corporation; or
- the redemption is for stock of a public regulated investment company.
Each of the tests under IRC Section 302 contain specific requirements (some subjective and some objective) which must be satisfied to qualify thereunder. It is therefore important to confirm that the redemption meets the requirements of one of these tests if sale or exchange treatment is desired. If the redemption does not fall into one of the above categories, then it will be an IRC Section 301 distribution.
If characterized as an IRC Section 301 distribution, then the payment for the stock will be treated as a dividend (generally, ordinary income – but see below discussion) to the extent of the corporation's earnings and profits, then a tax-free return of the shareholder's basis in the redeemed stock, then as capital gain.
Although a shareholder receiving an IRC Section 301 distribution will likely have to include part of the distribution in the shareholder's income as a dividend (generally, taxed at ordinary income rates), (i) if the shareholder is an individual, trust, or estate (i.e., a non-corporate shareholder), and (ii) the distribution is from a domestic corporation, the dividend component will be a "qualified dividend" and, therefore, taxed at capital gains rates. Thus, if the dividend is a "qualified dividend," then the dividend will be taxed at the same tax rate as an IRC Section 302 distribution. However, the amount of gain included in the shareholder's income may differ given the specific rules under IRC Section 301 vis-à-vis IRC Section 302.
It is important that a shareholder be aware of the different tax treatment that will result depending on whether a redemption of all or part of their stock is properly classified as a sale or exchange under IRC Section 302 or as a potential dividend payment under IRC Section 301 so that there are no surprises regarding the amount of net, after-tax proceeds the shareholder will receive.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.